Annuities are particularly important in any type of planning, whether financial or estate, as they are designed to pay the insured a regular income over a specified number of years. Annuities protect against the annuity-holder from “living too long.” In addition to providing income, most annuities have some sort of death benefit – a benefit not available by other types of investments. By assuring continued payments for a specified or unlimited number of years, annuities guarantee that the insured will not deplete his or her source of income. Although annuities have been around for years, in recent years annuities’ income growth is indexed according to the growth or decline of an outside fund, such as Standard and Poor’s 500, or some other indexing method. This allows the annuitant’s annuity value to fluctuate with the state of the economy, making it most competitive with other forms of investments, such as stocks, bonds, mutual funds, etc.
It is assumed that those using this text are already familiar with the concept of annuities, however in order to better understand the more complicated interest-sensitive types of annuities and their usage, a brief review of the basics of annuities should be helpful.
The time period over which the insurance company promises to provide income varies by type of contract is logically called the Annuity Period. The contract may specify an exact number of years or the individual’s lifetime (an unspecified number).
The person who purchases the annuity is the owner. The person who received payments from the annuity is the annuitant. The annuitant may or may not be the contract owner.
Annuities may be written on an individual, joint or group basis. The most common is the individual annuity that is usually purchased for retirement purposes. The “Joint and Survivor” annuity is also a common form for married persons. With this type of annuity, there are two persons insured and payments are guaranteed to continue to the surviving spouse upon the other’s death. Annuity payments can be either the same or different amount, usually designated as a percentage of the original amount (discussed in more detail later). Group annuities are generally part of a group pension or similar employee benefit plan.
There are two basic types of annuities in regards to when benefits start (when the annuity “annuitizes”).
With an immediate annuity, annuity payments will commence after a predetermined “period.” The period can be one year, for instance, in which case the first benefit payment will be one year after the purchase of the immediate annuity. Payments can be monthly, quarterly, semi-annual or annual. If period is one month, annuity payments start one month after purchase.
With annuitization, the payment period is scheduled to begin at some future date. The period when the contract annuitizes, is called the maturity date. Conversely, for definition purposes, the period prior to the maturity date is called the accumulation period. Further, the period following the maturity date during which payments are made is the liquidation or distribution period.
If death occurs before the annuitization period as stated in the contract, the cash value paid to the annuitant’s beneficiary would equal the amount of premiums paid in. However, most contacts provide for payment to the beneficiary of at least the amounts paid in - plus interest and regardless of sales charges.
The purchaser of a Deferred Annuity is permitted to alter the date that payments are scheduled to begin but within certain conditions that are plainly stated in the annuity.
The specific premium amount depends on several factors, primarily the length of the guaranteed benefit payment period. The “Straight life” (discussed later) annuity offers maximum income per dollar of outlay. Obviously, the reason for this is that some annuitants will die prematurely, or in the early part of the annuitization, thereby restricting the total amount of payout. Period certain and refund options provide less income per dollar of outlay, as the element of mortality does not enter the equation.
The interest the company earns on investments is an important factor in determining annuity premiums. The higher the interest, the more income per dollar of outlay. During the discussion of Variable and Equity Index Annuities, the effect of the company’s investment portfolio is extremely important. Obviously, the higher the investment return the lower the premiums to the annuitants.
The third factor is the expenses of the insurer. If the insurer has high expenses (such as high commissions and overrides), the higher premium to the policyholder. In other words, the lower the expenses, the lower the premiums paid to the insurer that is required by the insurer to pay all claims and satisfy their stockholders.
Bertrand, age 66, and his wife, Louise; also age 66, talk to their insurance agent about the purchase of an annuity that will pay $1,000 to each of them for his/her lifetime. Since Bertrand is a CPA, he has an interest on how the premiums are calculated. Their agent refers to his company’s actuarial department, who offers the following explanation:
The Insurance company assumes an earned interest rate of 8% on the investments that they purchase using the premiums paid by the insured.
Bertrand’s single premium cost would be $9088. Louise’s premium would be $8890.
Difference in premium would be $198. Therefore $198 would be liquidated the first year (one-year difference in ages).
8% of $9088 = $727.04.
Added to the one year cost difference ($198) would be $925.04.
Since the company promises to pay $1,000, the company would be $74.96 short.
This (annuity) concept may be difficult for people used to Certificates of Deposit and other savings vehicles to comprehend. As an insurance product, annuities are calculated on the participation of many people. Thus, when they start receiving annuity payments, those funds will come from a pool of funds that provides this income to those who live long enough to receive it. The $74.26 represents the insurance benefit that annuitants that survive to age 66 would receive, based on calculations on the number of annuitants that are likely to die that year. Therefore, the death benefit to surviving annuitants will grow larger each year during the liquidation period. If the annuitant lives long enough, both principal and interest eventually will be exhausted, and entire payment will come from the insurance benefit.
Single Premium immediate annuity premiums are paid when the contract is signed, hence the term “lump sum payments.” The funds for the payment of premiums can come from a variety of sources such as Employee profit-sharing plan, Savings Accounts, cash value of life insurance policy or sale of home or property, etc.
In today’s market, many annuities are purchased as the result of an IRA, 401(k) or 403(b) rollover. When this is done, it is extremely important that it be a “Section 1035” exchange, i.e. that it not be a taxable exchange unless, for some reason, the customer wants to pay taxes on the amount of the rollover at that time. The insurance company will furnish the papers that must be executed for such a rollover to exist and as discussed elsewhere in this text, the funds must be automatically transferred to the new annuity.
Periodic Level Premiumsis a typical payment method of Deferred annuities. The annuitant pays equal premium amounts at regular intervals, until the benefits are scheduled to begin. Some individuals choose this option, as it is similar to making deposits into a regular savings type account.
Periodic Flexible Premiumsis a premium payment method that is more “in tune” with today’s investment world. The annuitant pays the premiums over a period of time, until they are paid off. Since the premiums are flexible, they appeal to those who want flexibility in the timing and amount of premium payments and is particularly attractive to those who want a program in which they can vary the amounts they save each year. This also appeals to those who earn commissions, or other types of irregular income such as actors, fruit-truck drivers, artists, etc., not to mention families with growing children. As long as the annuity remains in effect, funds will continue to accrue interest. The principal disadvantage is that the actual amount of annuity benefit cannot be determined in advance, which may be essential in financial planning.
An Annuity Certain specified the number of benefits payments of a set amount. This option will guarantee a minimum amount that the insurance company will pay on an annuity. The annuity has a Death Benefit that provides for payment to be made to the designated beneficiary upon the annuitant’s death and will continue as long as the beneficiary lives. In effect, this annuity says that it will pay the benefits remaining of the period certain to the beneficiary. However, if the annuitant should survive the period certain, then the annuity performs as a Life Annuity.
CONSUMER APPLICATION
Cecil dies 3 years after taking out an Annuity with a 5-year period certain. The Annuity Company will continue to make payments to his beneficiary for next two years. Insurance companies usually pay the present value of the remaining payments in a lump sum, so Cecil’s beneficiary will receive 2 annual payments
If Cecil had survived the first five years of annuitization (liquidation period), the annuity would have continued to be paid out in the normal manner, ceasing upon the annuitant’s death.
The most common type of annuity is the simple “Straight Life Annuity” which provides for guaranteed periodic payments that terminate upon the death of the annuitant. Once the annuitant dies, the contract is fulfilled and no payments are made. This type of annuity does not guarantee that the annuitant will receive payments equal to the amount paid as premiums on the contract. If the annuitant lives a long time, they will recover more than all of the premiums they have paid; if they die soon after annuitization, the insurance company will only pay the benefits up until the time of death.
In the event the annuitant dies during the accumulation period (i.e. the time that payments are being made on the annuity, but prior to annuitization) proceeds will revert to the beneficiary, or if none is named, to the estate. Because this limits potential payouts, it will provide a higher return than other plans.
The Straight Life Annuity provides the maximum income per dollar of outlay.
The Life Income with Period Certain (probably named by a dyslexic Actuary…) guarantees that annuity payments to a beneficiary will be made for a specific number (or certain period) of years, even if the annuitant dies before the end of this period. Payments to the annuitant will continue as long as he or she lives.
The Life Income with Refund type of Annuity states that in event of the annuitant’s death, the company will pay an amount at least equal to the total dollars paid in as premiums. The company will continue to pay the guaranteed amount of monthly income for as long as the annuitant lives.
There are two types of this annuity:
NOTE: Annuities with refund options pay annuitants lower amounts of income than do comparable contracts without them. The refund option represents an extra benefit for the contract owner and an extra cost for the company.
The Temporary Life Annuity is a “combination” plan. Annuity payments will be made until either (a) the end of a pre-determined number of years, or (b) until the death of the annuitant, whichever comes first.
Under this arrangement, two people are insured, usually husband and wife. Beginning on the date set in the contract, payments are paid to the annuitants. Payments are guaranteed to continue to the surviving spouse upon the other spouse’s death. Depending on the terms, the continuing payments will either be in the same amount as when both annuitants were alive, or be reduced.
Two types are commonly used.
1. Joint and 2/3 survivor, the surviving spouse receives two thirds of the income paid to the original annuitant.
2. Joint and one-half survivor, surviving spouse receives half of the income.
Obviously, the premiums are higher than those for life income annuities are since the likelihood of a long annuity payment period is greater when more than one life is covered.
The first Variable Annuity was the College Retirement & Equities Fund (CREF), designed by Teachers Annuity and Insurance Association. Since that time it has grown into one of the most successful and heavily used insurance product in financial planning.
One of the earliest deviations from traditional fixed annuities was the Variable Annuity, which offers the potential for a greater rate of return if the annuity owner is willing to take a greater investment risk. Fixed annuity premiums are deposited in the insurance company's general investment account so that every annuity buyer's funds are commingled and the insurance company takes the risk on the investments it makes as a whole. With a Variable Annuity, however, premiums are invested separately, with the buyer assuming all of the investment risk.
Premiums deposited in a Variable Annuity go into a separate account where they are invested in a variety of securities, similar to investing in a mutual fund. Because Variable Annuity premiums are used to buy securities, they are subject to fluctuating market conditions, resulting in a variable rate of return that depends upon the performance of those securities. There are no guarantees about the value of the annuity at any given time since the value depends upon the separate account performance. Not even the principal amount invested by the annuity owner is guaranteed, which means it could be diminished or lost entirely.
Insurance companies continue to add optional types of investment portfolios for Variable Annuity buyers to choose from. Typically, investors may choose from such securities as common stocks, bond funds, U.S. government securities, short‑term money market instruments and others depending upon their investment needs. For example, the insurer might offer different funds whose separate goals are long‑term growth, capital preservation, high yields, or some combination. The annuity buyer may switch investments, if desired, subject to any insurer limits on the number of times changes may be made.
Historically, over many years, the markets rise ‑ and fall periodically, but generally provide an average long‑term rate of return that is greater than fixed rates. However, regardless of past performance, it is important to note again that absolutely no guarantees are made about the performance of the Variable Annuity separate account.
Because the separate account is invested in securities, Variable Annuities are regulated in part by the Securities and Exchange Commission (SEC) and in part by state insurance departments. The SEC requires that potential purchasers of Variable Annuities must be provided with a prospectus that discloses certain information about the underlying investments. This is the same regulation that applies to all securities Investments, such as mutual funds.
Agents who sell Variable Annuities must be licensed as securities sales people and registered as brokers with the National Association of Securities Dealers (NASD).
Funds invested in a Variable Annuity separate account are referred to as Accumulation Units. Rather than buying a certain number of stocks or having a specific dollar value, the buyer purchases "units" based upon the dollars invested and the total value of the stocks on the day of purchase.
A formula is used to determine the value of one Accumulation Unit:
Separate Account Value = Accumulation
Total of All Accumulation Units . Unit Value
As an example: The insurance company‑managed separate account value is $5 million and all of the investors own a total of one million Accumulation Units. Therefore, using the above formula, dividing the $5 million account value by one million total Accumulation Units results in a value of $5 per accumulation‑unit
$5,000,000 = $5
1,000,000
Therefore, a Variable Annuity buyer who invests $1,000 when the value of each Accumulation Unit is $5, can purchase 200 Accumulation Units: ($1,000 / $5 = 200)
Because the $5,000,000 account value can change daily according to market conditions, the value of this Variable Annuity could be higher or lower than $1,000 as early as the next day. For example, if the market took a nosedive and dropped to $4,000,000, with everything else remaining equal, the Accumulation Unit value would now be $4. This investment value is now $800 ($4 x 200 Accumulation Units) instead of $1,000.
Conversely, if the market improves markedly to where the separate account value is $6,000,000, and everything else remains equal, this investment value grows to $1,200. Obviously, this is a simplistic illustration of how the values fluctuate, as realistically, within a short period of time the values would fluctuate much more modestly and the total Accumulation Units would change as other Variable Annuity Units are purchased.
Note that while the value of the investment changed, the number of Accumulation Units the individual purchased (200), did not change. The investor will never have fewer Accumulation Units than the number purchased, although the value of those units changes in response to market fluctuations.
Every time investors make additional annuity payments, they buy more Accumulation Units based upon the value of one unit at that time. Using the same example, if investor would then pay $1,000 to the insurance company, the value of the separate account has risen and so has the total Accumulation Units owned by all investors.
$8,000,000
2,000,000 = $4
Annuity Premium $1,000 = 250 units
Accumulation Unit Value
At this point the investor purchases 250 additional Accumulation Units with the same dollars that previously purchased 200 units, although at this purchase each unit is worth less. This investor now owns 450 Accumulation Units and will always own at least that many units regardless of their value.
Because of the variability that characterizes these annuities, a similar mathematical computation occurs when the liquidation phase begins, as discussed later.
Loading is an addition to the pure cost of insurance that reflects agent’s commissions, premium taxes, administrative costs associated with the acquisition of new business, and other contingencies. The previous examples do not show the effect of loading (as part of the cost to the consumer of a Variable Annuity) on the amount of money that actually goes to work for the investor, nor of other charges imposed by the insurer.
The Variable Annuity has, in many cases, a death benefit which is payable to the heirs, and is, at least, equal to the amount of money invested into the Variable Annuity. This insurance guarantee will cost approximately 0.6% more in fees than a similar investment without this guarantee. In addition, most charge annual account fees from $30 to $40, which also diminish the investor’s total return. Loading and fees are not returned to the customer and do not contribute to the investment value of the Variable Annuity.
Immediate Variable Annuity fees vary by company, but one survey indicated that they approximate 1.8%. By comparison, some mutual funds will only charge 0.3 percent.
While most Variable Annuities are deferred annuities, the Immediate Variable Annuity has emerged as an interesting vehicle for some investors.
When an immediate Variable Annuity is purchased, the customer pays a lump sum to an insurance company and immediately starts receiving monthly payment. The payments will rise as fall, just as with a deferred Variable Annuity. And, comparing the immediate Variable Annuity to immediate fixed annuities, some investors like the idea of receiving different amounts each month, depending upon the performance of the stock market. It is generally believed that investments in the stock market will always beat inflation, therefore an immediate Variable Annuity will provide inflation protection that a fixed immediate annuity will not do.
People who are approaching retirement and have a large sum of money, are the best customers for this type of Variable Annuity which has have been around for several years, but only within the past 2 years have they grown in popularity. The reason, some experts believe, for the increased interest, is that older “baby-boomers” are willing to take on some risk, probably because the baby-boomer generation simply have not been saving enough, plus there is concern as to whether the Social Security program will continue when they reach retirement age.
However, most financial planners do not recommend an immediate Variable Annuity if the customer is not of retirement age. It is much less expensive for younger persons to maximize their 401(k) plans first. Actually, it may be cheaper for the person retiring with a substantial 401(k) to simply roll over the money into an IRA. It could also be rolled over to a mutual fund for less expense; however, the security of the financial strength of the insurer is not present.
While some investors are “queasy” about the Variable Annuity’s unfettered payouts – which is appealing to some, as stated earlier – some immediate Variable Annuities guarantee that monthly payments will never fall below a certain percentage (such as 80%) of the first payment received. As an example, if the first payment of the immediate Variable Annuity was $1,000, the annuitant would never receive less than $800. Please note, however, as mentioned various times in this text, for this “safety feature” there is a price. There is always a trade-off as where an annuity offers such a guarantee, as an example, an 80% guarantee would have a higher fee, such as 1.4%, while without the guarantee, the fee would be closer to .55 per cent.
Some insurance companies do not offer such “safety” features, because reinsurance companies have declined to reinsure this business (reinsures provide financial assistance to insurers by providing cash reserves) because they are afraid that they will have to pay large unanticipated sums if clients live beyond their life expectancy by 20 or 30 years.
One of the benefits of a Variable Annuity is management of the account by professionals when the separate account is company‑managed. With a company‑managed account, professional investment managers employed by the insurer decide which particular securities are included in the accounts made available to the investor. Again, this is similar to mutual fund investment management. As a result, the annuity owner is not required to monitor individual securities and decide whether to buy or sell.
For investors who have the time, temperament and desire, a self‑directed annuity account might be appealing. Experienced investors can personally choose their investment portfolios and decide how much of each premium will be allocated to the available investment funds. The investor typically may make changes in investment strategies during both the accumulation and liquidation phases. Although the annuity buyer bears the risk of any Variable Annuity, self‑directed annuities can be even riskier if the investor does not have the knowledge and ability to follow the stock market carefully and consistently.
Interestingly, since the market took a dive, there is an increased interest in annuities and one reason stressed frequently, according to many large annuity producers, is the desire of the annuitants to have their funds managed by experienced professionals.
The Death Benefit option was briefly considered in the discussion of loading and fees, above. As a matter of practice (and of law in some jurisdictions) deferred annuities provide some type of death benefit when the owner dies before liquidation begins. Variable Annuities create a special situation because account values can fluctuate violently enough to erase any death benefit provided by traditional means – as illustrated by the volatility of the stockmarket in recent years. Therefore, insurers have developed innovative optional death benefit provisions in order to guarantee minimum death benefits and take into consideration the potential increases.
A ratcheted or step‑up death benefit is an increase in the guaranteed "floor," which is the account value, provided the value of the investments has increased. The increase could occur every five years or at whatever interval the insurance company specifies. If death occurs, the survivors would receive the greater of two amounts: (1) the accumulated cash value (typically premiums paid plus separate account earnings) or (2) the increased value that last went into effect before the annuity buyer died. Under this option, the increase is tied directly to the performance of the underlying investments in the separate account.
The Death Benefit Adjustment is similar to the step‑up death benefit. Under this arrangement, at the end of the surrender charge period, the annuity owner may adjust the benefit to match what will be, (it is hoped) the increased value of the account. Again, any increase in death benefits is tied to the separate account performance.
A third death benefit option is more concrete than the ones previously discussed. The annually Increasing Death Benefit specifies a percentage by which the death benefit increases each year (e.g. by 5% of the years premiums), with an overall cap of 200%. This is tied only to the amount of premiums paid, not to the performance of the Variable Annuity separate account. At death, the survivors may choose to receive the account value if it is greater than the death benefit provided by this option.
Insurers who offer any of these options typically make them part of the standard Variable Annuity with no additional premium required. Where appropriate, additional costs to the insurer are built into the premium, but for the most part, the annuity buyer is expected to live to the liquidation phase, so annuity death benefit costs are not usually a big risk for the insurance company.
When the liquidation phase begins the insurer starts paying income to the annuitant on a regular basis. The total cash value accumulated for the amount of the lump sum with a single premium payment is annuitized by the insurer using established procedures that consider:
The age consideration involves the annuitant's age when the liquidation phase begins. For example, an annuitant that wants to begin receiving lifetime income at age 55 will receive smaller payments than one who waits until age 65. In the former case, the insurer makes a commitment to pay lifetime income for what is assumed will be a longer period.
As discussed earlier, since some states use “Unisex” ratings, premiums would be the same for male and female. From all of the factors considered (as discussed earlier), the insurer arrives at a certain "fixed" dollar amount of income the annuitant will receive every time an annuity payment is made.
In their original concept of Variable Annuities, one of the "variable” parts of Variable Annuities was the amount of each income payment. However, many annuitants were unhappy with the uncertainty of each payment amount, so insurers now permit payments from Variable Annuities to be determined in the same way as fixed annuity payments - each payment remains constant during the liquidation phase. The amount is based upon the value of the annuity when liquidation begins. Therefore, at the liquidation phase, the only remaining "variable" in the Variable Annuity is the interest rate, or earnings, paid on the remaining principal. While most annuitants (about 90% currently) prefer this type of payout, insurers will make variable fluctuating‑amount payouts if the annuitant desires.
Under the original variable payment method, Variable Annuities require a different means to determine the payout. When the liquidation phase begins, the insurer uses the number of Accumulation Units to arrive at a number of Annuity Units. Annuity Units are an accounting measure representing a fixed number of payout units rather than a fixed number of dollars. The determination of the exact number of Annuity Units resulting from the annuity’s accumulation value, is as follows:
First, the insurer determines the dollar value of the accumulation account by multiplying the number of Accumulation Units times the value of each. (This is the same calculation used to determine value during the accumulation period.) If the value of each unit is, for example, $5 and the annuitant has 50,000 Accumulation Units, the value is $250,000.
Then, using annuity tables that consider such things as age, sex (where permitted), the insured’s guarantees and any transaction charges or loading, the insurer then determines the dollar amount that will be paid per $1,000. For example, assume the payment will be made monthly and the tables indicate a payment of $10 for every $1, 000 of value. The annuitant in the example has $250,000 or "250 thousands" - $10 times 250 equals a monthly payment of $2,500, which is the amount the annuitant will receive for the first payment. Once the number of Annuity Units has been determined, that number remains the same during the entire payout phase. However, the value of each annuity unit varies according to the performance of the investments in the separate account. This means the amount of each payment can vary. Sounds complicated? Keep reading…
In the previous example, the value of each annuity unit was $5. Dividing the $2,500 payment by $5 results in the number of Annuity Units - 500 in this case. From this point forward, the monthly payment is equal to 500 Annuity Units times the value per unit at the time the payment is made.
Using the same example, if, during the next month, the value per unit has dropped from $5 to $4, then the monthly will be ($4 times 500) Annuity Units or $2,000. Later during the annuitant's lifetime if the value rises to $7, it would result in a monthly payment of $3,500. Throughout the “liquidation period” fluctuations continue as the separate account investments fluctuate.
Fixed annuities have been perceived as essentially risk‑free in terms of safety of the principal amount invested. The primary risk associated with fixed annuities was inflation risk - the possible loss of purchasing power resulting from high inflation. Variable Annuities, on the other hand, greatly increase the investment risk to the annuity owner with the hope of offsetting the inflation risk. Need it be said again?? “The higher the risk, the greater the reward.”
Insurance company annuities have on occasion, been compared negatively to bank savings instruments in regard to safety of principal since bank deposits are protected by deposit insurance and annuities are not. However, careful selection of the insurance company that provides the annuity virtually eliminates the question of financial soundness.
In addition, many states have guaranty funds or associations that basically serve the same purpose as bank deposit insurance. If an insurer becomes insolvent, guaranty funds provide the means to continue servicing the insolvent company's policyowners, including annuity owners. Funding comes from assessments all insurers in the state are required to pay. In some cases, guaranty laws apply only to insurers domiciled in the state, while others cover any insurer doing business in the state. Still, to be fair, the FDIC that guarantees up to $100,000 per person for investments in bank CD’s, is funded by the Federal Government that applies anywhere in the U.S.
As for risks involving future income, only an annuity can guarantee a lifetime income stream to the buyer. For example, money deposited in a savings account and withdrawn periodically during retirement can run out eventually. But the annuity buyer can be guaranteed lifetime income - even if the annuitant is still alive when the original principal and interest amounts are depleted.
While both fixed and Variable Annuities are capable of earning a competitive rate of return, Variable Annuities, in particular, provide greater opportunity to earn a higher rate of return on investments in the separate account - but, of course, earnings may fluctuate during the life of the annuity. Interest rate guarantees vary widely among insurers, providing a broad range of options. Careful shoppers will also look at the investment management track records of companies offering Variable Annuities. While past performance is no guarantee of effective future account management, investors can identify companies whose annuity returns have increased over time.
And, as frequently stated, not only have annuity interest rates become competitive with other investment products, but annuities also enjoy deferral of income taxation on earnings. Returns on bank products and securities are taxed as current income in the year they are paid to the investor. Even Variable Annuities, with their reliance upon securities to determine income, are eligible for tax‑deferred interest.
A particular advantage that a non-qualified Variable Annuity has over mutual funds in this present market environment is the fact that there are no capital gain taxes within the Variable Annuity accounts. The ability to transfer funds between subaccounts with taxation is a huge benefit because many mutual fund investors have become very frustrated by the capital gains tax bills that they receive at the end of the year when they watched their mutual funds only decline in value! Mutual fund representatives have had to do a lot of explaining. True, variable subaccounts have decreased also during this period of time, but the annuitant was able to avoid intermediate taxation and still have the ability to adjust within the subaccounts.
Because Variable Annuities offer a fixed account among the investment choices is a distinct advantage over mutual funds. This fixed and guaranteed fund provides comfort to many investors during this time of market fluctuations. Even those who normally invest in the variable stock and bond funds and are long-term investors, since they can ride out the volatility of the market in a fixed environment, and to do so all within one product, are more-and-more being attracted to Variable Annuities.
Since annuities are intended to be long‑term investments, penalties are assessed under certain circumstances if the owner withdraws all or part of the annuity's value. These charges can be substantial in some situations.
Typically, the annuity owner can withdraw 10% during the first year, with an additional 10% increase each year until the final year of the annuity term. As an example, with a 7-year annuity period, the first year 10% could be withdrawn without penalty, the second year it would be 20%, 30% the third year, etc., until the end of the accumulation (annuity) period.
Some of the plans offer surrender-free withdrawals for terminal illness, for confinement in nursing homes, and other similar situations.
Variable Annuities are generally a tax-favored investment product when purchased by an individual on a non-qualified basis. When purchased as part of a qualified retirement plan, such as an IRA, 401(k),TSA-403(b), or Deferred Compensation Plan – 457, they are taxed under the special tax provisions governing that qualified retirement plan.
The Taxpayer Relief Act of 1997 brought two key changes that can affect Variable Annuities as to their marketability.
1. Long-term capital gains rates were pared to a maximum of 20%. Those who own investments outside of tax-deferred accounts and meet the 18-month holding-period requirement, face a much lower tax burden on any gain realized. On the other hand, investment income from a Variable Annuity is taxed at the ordinary income rate, which in many cases is higher than the top capital-gains rate.
2. The Roth IRA was created. It works much like a tax-favored retirement account that mimics a Variable Annuity. The customer puts money into the account and investment earnings are not taxed unless the money is withdrawn too early. The funds can be shifted between investment vehicles without tax consequences as long as the funds stay in the IRA.
In a Roth IRA, as long as the money stays in the IRA for at least 5 years, and it is not withdrawn before retirement; the funds are withdrawn tax-free. If, conversely, the money was put into a Variable Annuity, the annuitant would pay tax at the ordinary income tax rate at retirement. (Also there are restrictions for Roth IRA – single income must be below $95,000, or $150,000 married filing jointly.) Since there are no restrictions as to income for a Variable Annuity, if a person made too much money to contribute to a Roth IRA and trades too actively to enjoy the long-term capital gains rate, a Variable Annuity would be the way to go.
The Variable Annuity has proven that it is a formidable financial planning tool and with its “sister” annuity, the Equity Index Annuity (discussed later) has grown significantly in usage for estate and financial planning purposes. Some of those applications are:
Loren is 42 years old and has just inherited $25,000, which he wants to invest for the future, so he purchases a Variable Annuity. The annuity returns 7% after subtracting a management fee and other expenses, which include a mortality fee that guarantees that when Loren dies, the Variable Annuity will not be less than $25,000.
20 years later, when Loren reaches age 62 and is concerned about retirement funds; the $25,000 has now grown to $97,000, an increase of $72,000. This amount ($72,000) is considered regular income and not as a capital gain. Depending upon the tax laws at that time, it is possible that Loren’s taxes may be higher than if the money had been invested in a mutual fund if capital gains taxes are lower than taxes on regular income. It would probably be best for Loren to take a series of payments, instead of a lump-sum payment, which would spread the taxes out over the payment period.
If the stock market should collapse after Loren has had the Variable Annuity for about 3 years, unfortunately Loren would have to pay a sizeable penalty for early withdrawal should he desire to do so. However, since a Variable Annuity should be purchased as a long-term investment, over the 20-year period, the market should probably also go up again.
Chris and Bertha are in there 70’s and received $100,000 from the sale of the estate of Bertha’s sister. They have been retired for several years and really do not need additional retirement funds. They contact their agent, Lambert, who is an insurance agent and registered representative. They told Lambert that they wanted as much of this money available as possible in case of an emergency. Also, they wanted as much money available as possible to the survivor when one of them died.
Lambert recommended a Variable Annuity because of the tax-deferral features and because of the growth of the stock market. Lambert had to search the market in order to find the “right” Variable Annuity, i.e. an annuity that provided the best returns and still allowed an easy “way out” in case of an emergency. He found a product with a 1.25% insurance and administrative
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charge. The product had a death benefit, which was equal to the highest account value the contract had ever reached. It also allowed for early withdrawal for certain situations, nursing home confinements, terminal illness, divorce and disability. It also had a death benefit feature that resets the contract value each anniversary, and then arrives at a guaranteed amount at age 81.
He used an optional death benefit which pays 15% of the annual contract growth as an estate benefit which means that the surviving spouse can have the money if they so desire, or it can be kept in the contract if they do not need the money immediately.
Under this option, the surviving spouse would incur no income taxes, and the taxes can be deferred throughout his/her lifetime. This amount is added to the contract value and if not paid out, it will continue to grow, in effect increasing the size of the estate. On an annuity of $100,000, over 10 years this $15,000 would grow into nearly $30,000 (at continued growth of 7% which would be far surpassed if the stock market continues to grow at the rate it has over the past 10 years) which could be used to help pay taxes if this money is needed, or it can be passed to the heirs.
A recently innovation of annuities and in particular immediate annuities, is the “enhanced” annuity, also known as a “substandard” annuity. The theory is that if a person’s health is such that they would be declined or heavily rated for life insurance, then an annuity issued to such a person would provide higher payouts - or require smaller deposits to achieve the same results. In effect, since added mortality increases the cost for life insurance, therefore it follows that added mortality should increase the payout for annuities.
Should payouts to healthy annuitants be subsidized by the increased mortality (and reduced longevity) of the insured? There is another element of “unfairness” – as assets increase with age, so do issues of deteriorating health. An annuity is designed specifically to provide the guaranteed income that the annuitant cannot outlive.
Annuities have been used for structured settlements, and in many cases, the annuities are underwritten using an age rate-up method of increasing payments. About 6 years ago, a health questionnaire was introduced in the U.S., an approach used in England several years previously. Smoking is the most important question as it is the largest single mortality factor. Some applications only have a the smoking question as the only question asked.
In England, the companies use a lifestyle questionnaire and this has been adopted by some U.S. companies. These other underwriting factors include marital status, geographic location, occupation, socio-economic status, etc.
What types of annuities are used? The limited experience indicates that the unbundling of various types of annuities is important. Some companies are packaging these annuities with long-term care or critical illness benefits, some of the newer Variable Annuities in this market have an enhanced earnings benefit that provides additional payouts to cover taxes and other incidental needs.
Annuitization is infrequent – according to LIMRA, in 2000, 2.1% of fixed and .06 of Variable Annuities were annuitized. Therefore, annuities are very much a growth product, and innovations such as the enhanced annuities, can be expected in the future, and should be welcomed.
Annuities pay an important part in financial planning, and have been an integral part of this process for many years. Recently there has been a change in the use and marketability of annuities, driven by the economy, the low interest rates, and the “bullish” stock market. Surveys have been made by various publications and organizations in respect to what has happened to the annuity market and the popularity of annuities in financial planning.
If the economy were different, for instance if inflation was 2%, interest rates on “risk-free” investments such as CD’s were around 8%, and the stock market would go down as much as going up, then investment choices would be different. In recent years, this would probably indicate an excellent market for fixed annuities. But today, this is not the case.
One large brokerage firm that specializes in annuities in a Life Insurance Selling article discussed their experience in the changing annuity market. Their experience parallels those of other annuity brokerage firms and is worth discussing in this context.
In 1992, the annuity brokerage business was nearly totally the traditional fixed deferred annuities with one year guaranteed interest rates. In the second half of 1999, these types of annuities had fallen to where they were only about 25% of their total brokerage annuity premium.
The reason that the number of fixed annuities have decreased is because interest rates have been going down since about 1982, and that downward interest rates continued from 1992 to 1998, with a sign of some increase in 1999 and early 2000, but dropping drastically since. As interest rates moved down, bond prices moved up, and insurance companies were induced to sell their bonds so as to realize the gains and to invest in other obligations as required by regulatory authorities.
Renewal interest rates on one year guaranteed annuity rates were realigned to reflect new lower bond interest rates. It was customary for annuities to renew at or near the present (current) interest rates, which were consistently lower. Annuitants that had a 9% return on their annuities, found themselves with 5% returns and were not happy. Some agents were quite unhappy also, as they had expected that the fixed deferred annuities would at least maintain their original base rate renewal levels. Where customers expected that returns would not drop to these levels, their agents found themselves losing business and losing “face” among their customers.
One large brokerage firm has gone from nearly 100% fixed deferred annuities less than 10 years ago, to only 25% one-year guaranteed rate annuities, 30% long-term guaranteed annuities, 8% single-premium immediate annuities, and 37% equity index annuities.
The long-term guarantee annuities feature interest rate guarantees that run from 5 to 10 years, usually with an option to surrender without penalty at the end of the interest-guarantee period. This changes the design of the fixed annuity to where it is much more palatable now. Since these 5 - 10 year rate guarantees are often higher than one-year base rate guarantees, this product is increasing in market share.
The single premium immediate annuities are becoming more popular, for whatever reason. While there seems to be nothing totally specific about the attractiveness of this product, it is felt that the general trend towards fully guaranteed annuities is increasing for a variety of reasons. (This was discussed early in this text)
The Equity Index Annuities has been explored in detail in this text, and the brokers are all excited about this new product and predict a solid place in financial planning.
CHAPTER 6 – STUDY QUESTIONS
1. The “Annuity Period” is
A. the time period, over which the insurance company agrees to pay income.
B. the time period, in which the annuitant deposits money into the annuity.
C. the time period that the insurance company guarantees a death benefit.
2. In a Deferred Annuity, the period following the maturity date is called
A. the accumulation period.
B. the annuitization date.
C. the liquidation or distribution period.
3. The type of an annuity, that provides for guaranteed payments that terminate upon the death of the annuitant is known as
A. Life Income with Period Certain.
B. Life Income with Refund.
C. Straight life.
4. With a Variable Annuity
A. the value of the annuity is guaranteed.
B. the principle invested by the annuity owner is guaranteed, but not the rate of re-turn.
C. premiums are deposited in a separate account.
5. The main advantage of a non-qualified Variable Annuity over a mutual fund is
A. the cash principal in the Variable Annuity is protected by FDIC and mutual funds are not.
B. the interest earned is tax deferred.
C. The interest earned in a Variable Annuity is always higher than in mutual funds.
6. The major advantage of a Roth IRA over a standard IRA is?
A. The money deposited accumulate tax-free and the deposits are tax deductible.
B. The money in the Roth IRA can be taken out, at any time, without any penalty.
C. The money taken out, upon retirement, after 59 ½, is received tax-free.
7. Susan buys an immediate Variable Annuity with 10 years certain. She receives $500 per month for 7 years and dies. Her beneficiary will receive
A. $30,000.
B. $18,000.
C. an undetermined amount.
8. A Joint and Survivor Annuity will be paid out to
A. two different people.
B. two people, both receiving the same amount.
C. the beneficiaries of the two people in monthly installments.
9. The value of an accumulation unit, in an Variable Annuity, can be determined by
A. multiplying the monthly premium by the number of months of payment.
B. adding the annual premium paid to the number of years paid.
C. dividing the separate account value by the total of all accumulation units.
10. What is the main purpose of an annuity?
A. to provide tax-free income for the life of the annuitant.
B. to provide financial protection against outliving assets.
C. to provide a tax shelter during the growth period of a person’s income production years.
ANSWERS TO CHAPTER TEN REVIEW QUESTIONS
1A 2C 3C 4C 5B 6C 7C 8A 9C 10B